Understanding The Risk In The BRICs

When Goldman Sachs economist Jim O'Neil first dubbed the four nations of Brazil, Russia, India and China as theBRICs, back in 2001, he made one of the gutsiest long-term global macroeconomic calls of all time. Featuring the right demographics, vast commodity wealth, growing middle classes and relatively steady fiscal andmonetary policies, O'Neil postulated that these nations would be the biggest drivers for future global growth. So far, the economist's prediction has generally come true. The MSCI BRIC index has risen by more than eight times what the S&P 500 index returned during the past decade, and the BRIC's combined GDP soared to $13.3 trillion last year.

That outperformance has prompted many investors to add the four horsemen of the developing world to their portfolios as a way to cash in on the group's torrid growth. Despite the rosy long-term growth picture for the BRICs, there are plenty of risks, aside from the global macroeconomic pressures in these nations. In the end, these nations aren't called "emerging" for nothing.

With the BRICs continuing to contribute so much to the global economy and with the nations making up a huge portion of emerging market assets, it is critical for investors to understand these risks. Yet, each of the four nations is a completely different animal and comprehending the differences in each of their risk profiles can be a daunting task. Here are some of the internal risks when investing in the BRICs.

A Dragon of Lies
When it comes to emerging market investing as a whole, China remains at the top of many investors' minds. After all, the nation represents the hallmark of the developing market thesis. However, investing in Asia's Dragon economy isn't as easy as buying stock in Germany. 

Perhaps the biggest problem is the lack of GAAP or international accounting standards. That issue has even caught some of the best investors by surprise. For example, billionaire hedge fund manager John Paulson lost a bundle on Toronto-listed Chinese forestry firm Sino-Forest Corp. It was accused of faking land holdings and "cooking the books." Others have been accused of falsifying bank deposits and accounts. That lack of transparency and disclosure of information makes it a lot harder to see the real picture, especially compared with developed market stocks.

That picture gets even muddier when investors are forced to deal with questionable official Chinese data and a heavily regulated/bureaucratic communist government. The majority of the major firms in the nation are in some way owned or controlled by Beijing.

Russia's Corruption Woes Despite the nation's recent entry into the World Trade Organization (WTO), there are still somesignificant investment risks in Russia; corruption and political will are the two biggest. Bribes and organized crime infiltrating legitimate businesses remain standard practices. According to a report by the Information Science for Democracy Foundation, the average amount of petty bribe in the Russian Federation has increased steadily in the last 10 years. Back in 2001, it was roughly 1,817 rubles. By the time 2010 rolled around, it had grown to 5,285 rubles and represented 93% of an average worker's salary.

Then there is the national government to contend with. Voicing an opinion that conflicts with President Vladimir Putin's wishes could lead to your business or investments being seized as well as a potential prison sentence. Just ask Mikhail Khodorovsky, former Chairman and CEO of Russian oil giant Yukos, who was convicted of fraud in 2005 for reasons that are believed to be politically motivated.

LATAM's Commodity King
While outright corruption isn't as big of a problem for Brazil as it is for Russia, the government does have a hand in creating risks for investors that stem from its "protectionist" attitude. The country now has the second-highest number of protectionist measures in Latin America, after Argentina. This includes rules to favor local products, high tariffs on imported goods, tax breaks to encourage domestic production and limiting the access of foreign investors to strategic natural resource assets. For example, investors wanting to tap the nation's vast oil wealth must partner with state-owned energy giant Petrobras. Overall, these policies could derail some investment returns if Brazil decides to go one step further and nationalize various assets.

Asia's Bureaucratic Nightmare
With a democracy as large as India's, you would expect there to be some red tape when it comes to successful investment. However, the nation's bureaucracy has been called the "most stifling in the world." Starting a business in India is incredibly hard, as the local and national governments generally have a hand in the commercial markets. Likewise, enforcing contracts can be impossible, especially when there is a propensity for business partners to enter into undeclared third-party transactions. The Political and Economic Risk Consultancy, a Hong Kong-based think tank, estimates that India's bureaucratic system will prevent it from matching the growth rates of other rival nations.

The Bottom Line
The BRICs offer much in the way of portfolio and economic growth, however, there are some pretty big risks for individual investors as well. Understanding these risks is key to navigating these emerging giants successfully.